10/21/2009 @ 12:00AM

A Temporary Hiring Tax Credit?

The worst of the financial crisis passed early this year, yet employment continues to decline with more than 2.6 million jobs lost since February. And continued job loss is leading to calls from various quarters for more short-term stimulus policies to expand employment. A recent stimulus proposal, gathering considerable attention is a “hiring tax credit,” in which businesses that expand their employment receive a temporary tax credit for new hires. (The New York Times discusses the basic idea behind the tax credit.)

Businesses, however, are somewhat divided about such a policy, with some companies expressing reservations about whether this idea will generate much new hiring, while others support it. It might seem odd that what apparently is a very pro-business program has detractors among leaders in the business world. This division is not surprising, because a hiring tax credit is a subsidy for at least some job creation, and subsidies result in winners–those who receive the subsidy and support it–and losers–those who don’t receive it and don’t support it.

From a business hiring perspective, the program clearly separates these two camps. The simplest principle behind hiring is that the value created by an employee must exceed the cost of employment. For many firms today, product demand remains weak, which means that there is a very large gap between the incremental value generated by a potential new hire compared to that worker’s employment cost. This means that companies in this situation are not expanding their workforce, and a hiring tax credit would not bridge the large gap between value creation and employment cost. This reasoning explains business responses such as:

“I’m a small business owner. Did anyone supporting this idea walk down Main Street (not Wall Street) and ask the small business owners exactly what these new employees would do once they were hired? Job growth comes after revenue growth and cash flow. It’s that simple.”

In contrast, there are some businesses experiencing increases in demand, and thus are expanding employment, even in our current weak economy. A hiring tax credit is a monetary transfer from taxpayers to these expanding businesses because at least some of their new hires would have been made even without the plan. This inability to identify marginal hires–those hires in which the difference between employee value added and employee cost is small–means that this program necessarily involves subsidies involving job creation.

But isn’t it possible that the credit will help induce many new marginal jobs? This is hard to say, as the difficulty in identifying marginal jobs makes it inherently difficult to determine how many jobs it would create. This program would create potential job matches in which a job applicant and employer would like to make a deal but simply cannot agree on employment terms. For example, if the monetary difference between the parties’ desires is small enough so that it can be bridged by a hiring tax credit, when there is nothing else the two parties could do to close the deal on their own.

Thinking about job creation this way should have a familiar ring to those of you who have bought or sold a home in which one or more realtors accepted a reduced commission as a last resort to close the deal. In this case, the taxpayer takes on the role of the realtor by taking a hit. But in contrast to the realtor who can identify the marginal deal, the taxpayer also takes a hit on a number of other deals that would have closed without any intervention.

By trying to target new job creation, a hiring tax credit has the potential of creating loopholes in government programs. For example, a program that subsidizes new hires over existing employees creates incentives to replace old workers with new ones. Gross flows of workers–the absolute numbers of jobs created and jobs lost within narrowly defined industries–are huge compared to net job creation within an industry. That is, even in industries with very little net job creation, such as manufacturing, both job creation and job destruction represent as much as 15% to 20% of annual total employment.

This means that the normal market forces of supply and demand already substantially reallocate workers across firms within an industry, with many workers moving from one firm to another. Changing the relative cost of a new hire compared to an existing worker would lead to even more worker reallocation across firms. But in this latter case, the reallocation would not reflect the normal competitive forces of moving resources from the least productive to the most productive firms, but rather would reflect the benefits from simply reallocating employees for a tax break.

The program might also treat new and established businesses differently, giving one type of business preferential treatment over another. Specifically, if start-ups were included, this would provide significant cost advantages to new businesses, since all of their hiring is de facto job creation. On the other hand, excluding start-ups provides a cost advantage to established firms and penalizes new business.

Another caveat is that the anticipation of such a plan creates an incentive to delay new hiring. That is, businesses may wait to add workers if they believe that a hiring tax credit is likely to be passed by Congress. This is also a significant concern, because employment tends to lag the business cycle, even after the economy has begun to improve. And businesses tend to increase the hours of existing workers, rather than add new workers to meet higher demand. Thus, this plan could perversely prolong the recession that it is intended to solve.

Many of the unintended effects that could arise from a hiring tax credit would be eliminated if the proposal were for a payroll tax cut, which does not confer a cost advantage to new hires over established workers. But while a payroll tax cut would seem to make better economic sense, it would face an uphill battle in Congress, with last year’s fiscal deficit coming in at $1.6 trillion, and with a large deficit in the coming year, reflecting both the weak economy and the deficit created by the American Recovery and Reinvestment Act.

Rather than continuing along the path of temporary “fixit” programs that may not work as intended, we should make long-run policy changes for which there is more economic support, such as revising and simplifying the tax code to increase the long-run incentives to work, save and invest. Recently, one of UCLA’s Ph.D. students in economics, from Argentina, remarked to me, “U.S. economic policy, with so many gimmicks, looks a lot like what we do in Latin America. Why is the U.S. doing this? It has never worked for us.”

Lee E. Ohanian is professor of economics, and director of the Ettinger Program in Macroeconomic Research at UCLA. He is the author of “New Deal Policies and the Persistence of the Great Depression,” with Harold Cole.